Debate over small-cap mutual funds: Should you halt, sell or increase SIP?

Will small caps recover, or is this the start of a prolonged downturn?

Earlier this month  Sankaran Naren, the Chief Investment Officer of ICICI Prudential Mutual Fund, issued a stark warning to investors about the risks associated with small- and mid-cap stocks, particularly those who have been investing through systematic investment plans (SIPs) since 2023. He believes that it's time for investors to completely exit these stocks, meaning they should sell off their holdings in small and mid-cap stocks without hesitation.

 

One of the first points he made is that small and mid-cap companies look extremely expensive right now—even compared to 2008, when valuations were already quite high.The total value (market capitalization) of small and mid-cap companies sits below the largest 100 big firms, which often makes them riskier to invest in.

 

 

What Did Naren Warn About?

Naren's warning came at an event in Chennai where he told investors that those who invested in small and mid-cap stocks through SIPs may face major losses. He pointed out that while many investors believe SIPs help reduce risk by investing over time, small- and mid-cap stocks have been experiencing declining momentum and are performing poorly. These stocks have dropped below their daily moving averages, meaning they are not performing as well as expected. He compared the current situation to the 2008-2010 financial crisis, where many investors, especially in banks, lost a lot of money. However, he said that the current risks are more severe for retail investors (the average individual investor), as companies today raise funds directly from investors through IPOs (Initial Public Offerings) or other placements, rather than relying on traditional banking systems.

 

He recommended to exit the small-cap space unless investors are willing to commit to their Systematic Investment Plans (SIPs) for a minimum of 20 years. In addition, diversification into megacap, largecap, flexicap, and hybrid funds was suggested.

 

Since Naren's comments, the market has seen a significant drop, especially in the BSE Small-cap and Mid-cap Indices. These indices have fallen by over 6% and 5.3%, respectively, causing many investors to lose money on their small and mid-cap stock investments. For example, the BSE Midcap and Smallcap indices, which were worth much higher amounts earlier this year, have now seen their values drop substantially. This sell-off has led to a broader market downturn, increasing volatility, which in turn has decreased investor confidence and led to foreign investors pulling out their money.

 

As of February 11, the average small-cap fund has been down by over 13 per cent since the beginning of the year, shows data analysed by Value Research. This correction has come swiftly, in less than two months, making many investors anxious about what to do next.

 

"History shows that small-cap funds often go through extreme ups and downs within the same year," said Value Research in a note. To understand this better,Value Research explains with the following table how small-cap funds have performed over the years, how much they fell within the year, their highest return point and where they ended. 

Note: Based on regular plans of small-cap funds with over 10 years of history. Source: Value Research

   

Key takeaways from the data

• Sharp falls within a year are common: Even in years when small caps delivered positive returns, there were significant drawdowns.
• Recovery after a crash is often quick: 2008 was a disastrous year (-62 per cent), but those who stayed invested saw a 99 per cent return in 2009.
• Short-term declines don't always mean losses: Even when markets fell during the year, the final returns were often positive.

 

"This reinforces a simple point: if you are investing in small caps, be prepared for sharp corrections. But history shows that those who stayed invested have been rewarded. Should you stop your SIPs in small caps? The simple answer: No, unless your asset allocation suggests otherwise. The key to small-cap investing is having a 7-10-year horizon and being prepared for volatility. If you have been investing with a structured financial plan, stopping SIPs due to a short-term decline could be counterproductive. Here's why: SIPs work best in volatile markets - By continuing your investments, you buy units at lower prices, improving your long-term cost average. Recoveries tend to be sharp - Small caps often rebound faster than large caps after downturns. Long-term returns outweigh short-term falls - As seen in past market crashes, staying invested has delivered better results over time," explained the Value Research team. 

 

In a recent post, Radhika Gupta, MD & CEO of Edelweiss Mutual Fund, wrote: “Since we are all trying to decipher whether to stop, start, time or play the dip, on something as simple as a SIP, some interesting data that may help... I had shared our midcap fund has a minimum 10 year SIP return of 8 pc. Here is similar data for indices (not index funds because you have to reduce fees / tracking error). Again no negative returns in midcap (although the active fund had alpha), and virtually none in small cap.”

 

According to Gupta, SIPs are intended as an uncomplicated, enduring investment strategy. She believes a well-managed combination of mid-cap and small-cap investments can be advantageous. Gupta highlighted that market fluctuations might yield unsatisfactory short-term returns, underscoring the significance of maintaining SIPs for a minimum of 10 years.

 

Based on data analysed by Motilal Oswal, the initial seven years of Systematic Investment Plans (SIPs) can significantly impact your returns, particularly in volatile markets such as small and mid-cap stocks. The analysis indicates that remaining invested in SIPs for this period can lead to substantial rewards, despite market unpredictability. Even in the worst-case scenarios for a 7-year SIP in mid and small-cap stocks, the probability of loss was a mere 5.8%.

 

The probability of loss in seven-year SIP is midcap 0.0%, smallcap 5.8%, and largecap 0.6%. Out of 155 monthly SIP series, only nine Series of SIPs in smallcaps ended the term at a loss. None of the SIPs in midcaps ended with losses, the report said.

 

The worst loss in smallcap SIPs was -7.3%. An interesting observation is that the worst returns across all categories (largecap, midcap, smallcap, and multicap) and across 5-year, 7-year, and 10-year SIPs occurred in March 2020, the report said.